While the discussion between horizontal and vertical equity generally applies to tax policy, we can also look at the class economics definition for the two terms and go over a few examples.
Horizontal equity means that we apply the exact same policy to people in the same situation. For example if two people earn both earn $25,000 per year they should both pay the same amount of tax. This means that if we have horizontal equity, we try to make sure that we do not make decisions based on non-income characteristics like ethnicity, gender, weight, sexual orientation, or job status.
Vertical Equity means that people with higher incomes should be required to pay more tax. The purpose of vertical equity is to to tax in a more progressive way. It goes by the principle that people with more ability to pay should pay more. The point of vertical equity is to redistribute wealth in the society in a more “fair” way, which implies that poor people get more happiness out of money than the rich do.
Horizontal equity is a must for most tax systems because citizens can become very upset if they are required to pay higher taxes based on non-financial characteristics such as marriage. Before the recent reform, married couples filing together in the United States paid more in taxes than an identical married couple would by filing separately. Consider the following example of horizontal equity:
John and Jane file together, and make 50K each. Because together they earn 100K, they fall into the 20% tax bracket, and pay 20K in taxes. While Adam and Alice file separately, because they each 50K each, they fall in the 10% tax bracket, and pay only 10K in taxes total. Because these people are in identical situations but pay different tax amounts, we see a violation of the horizontal equity principle.
What the recent tax reform did was raise the amount of income allowed by married couples, so that people in John and Jane’s situation would pay an identical amount to couples in Adam and Alice’s situation. This results in horizontal equity.
An example of a violation of vertical equity is a tax on food. Generally people (both rich and poor) will buy a similar amount of food each month. This means that both rich and poor will pay the same amount of tax on their food purchases. This violates the vertical equity principle because those who are able to pay more are not required to.
An example of vertical equity is the progressive federal income tax system in the United States. As someone earns more money, they have to pay a higher percentage of their income in taxes. While those with low incomes, pay lower percentages of their income in tax, or perhaps pay no tax at all.